08/11/2011

Introductory Econometrics: A modern approach (Wooldridge)

Chapter 1
The Nature of Econometrics and Economic Data

Dr. L Vn Chn FTU, 2011

Chap 9-1

1.1 What is Econometrics?

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Imagine that you are hired by the government to evaluate the effectiveness of a publicly funded job training program. You are to determine what, if any, effect the training program has on each workers subsequent hourly wage. Suppose you work for an investment bank and study the returns on different investment strategies. Answering such questions may seem daunting at first. Now you may have a vague idea of the kind of data to collect. By the end of this course, you should know how to use econometric method to formally evaluate a training program or strategies.
Dr. L Vn Chn FTU, 2011

1.1 What is Econometrics?

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Econometrics is based on the development of statistical methods for estimating economic relationships, testing economic theories, and evaluating and implementing government and business policy. The most common application is the forecasting of such important macroeconomic variables as interest rates, GDP, and inflation rates. Econometric methods can be used to study the effects of - political campaign expenditures on voting outcomes, - school spending on student performance in the field of education.

Dr. L Vn Chn FTU, 2011

08/11/2011

1.1 What is Econometrics?

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Econometrics has evolved as a separate discipline from mathematical statistics because it focuses on the problems inherent in collecting and analyzing nonexperimental economic data. Experimental data are often collected in laboratory environments in the natural sciences, but are much more difficult to obtain in the social sciences. Nonexperimental data, sometimes called observational data: the researcher is a passive collector of the data.

Dr. L Vn Chn FTU, 2011

1.2 Steps in Empirical Economic Analysis

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An empirical analysis uses data to test a theory or to estimate a relationship. How does one go? Step 1: Careful formulation of the question of interest. Step 2: To test economic theories, a formal economic model is constructed. An economic model consists of mathematical equations that describe various relationships.

Dr. L Vn Chn FTU, 2011

1.2 Steps in Empirical Economic Analysis

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E.g., Individual consumption decisions, subject to a budget constraint, are described by mathematical models. The basic underlying premise is utility maximization, which leads to a set of demand equations. Quantity demanded of each commodity depends on: - the price of the goods, - the price of substitute and complementary goods, - the consumers income, - the individuals characteristics that affect taste.

Dr. L Vn Chn FTU, 2011

08/11/2011

1.2 Steps in Empirical Economic Analysis

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Utility maximization framework is used to explain seemingly noneconomic behaviors. Classical: Beckers (1968) economic model of criminal behavior From his perspective, the decision to undertake illegal activity is one of resource allocation. y = f(x1,x2,x3,x4,x5,x6,x7)
y = hours spent in criminal activities, x1 = wage for an hour spent in criminal activity, x2 = hourly wage in legal employment, x3 = income other than from crime or employment, x4 = probability of getting caught, x5 = probability of being convicted if caught, x6 = expected sentence if convicted, x7 = age
Dr. L Vn Chn FTU, 2011

(1.1)

1.2 Steps in Empirical Economic Analysis

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Step 3: Turn an economic model into an econometric model. - The form of the function f(.) must be specified. - How to deal with variables that cannot reasonably be observed. E.g., econometric model of crime: crime = 0 + 1 wagem + 2 othinc + 3 freqarr + 4 freqconv + 5 avgsen + 6 age + u
crime = a measure of the frequency of criminal activity, wagem = wage earned in legal employment, othinc = income from other sources, freqarr = frequency of arrests for prior infractions, freqconv = frequency of conviction, avgsen = average sentence length after conviction.
Dr. L Vn Chn FTU, 2011

1.2 Steps in Empirical Economic Analysis

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0 , 1 , 2 ,... are the parameters, describing directions and strengths

of relationship between crime and the factors in the model. u is called error term or disturbance term, containing unobserved factors. Step 4: Various hypotheses of interest can be stated in terms of the unknown parameters. E.g., we hypothesize that wagem has no effect on criminal behavior.

1 = 0

Dr. L Vn Chn FTU, 2011

08/11/2011

1.3 Structure of Economic Data

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Cross-Sectional Data A cross-sectional data set consists of a sample of individuals, firms, states, etc taken at a given point in time. The data on all units do not correspond to precisely the same time period. We can often assume that the data have been obtained by random sampling from the underlying population. Ordering of the data does not matter. Sample selection problem, e.g., wealthier families are less likely to disclose their wealth. Look at WAGE1.
Dr. L Vn Chn FTU, 2011

1.3 Structure of Economic Data

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Time Series Data A time series data set consists of observations on a variable or several variables over time. E.g., stock prices, money supply, CPI, GDP, automobile sales. Past events can influence future events and lags in behavior are prevalent. time is an important dimension in time series data. Observations can rarely be assumed to be independent across time. more difficult to analyze than cross-sectional data. Special attention should be paid to the data frequency at which the data are collected. Look at NYSE.
Dr. L Vn Chn FTU, 2011

1.3 Structure of Economic Data

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Pooled Cross Sections Some data sets have both cross-sectional and time series features. E.g., HPRICE3: 2 cross-sectional surveys are taken in 1978 and 1981. In 1978, a random sample of 179 households is surveyed. In 1981, a new random sample of 142 households is taken using the same questionnaire. Combining the 2 years, we have a pooled cross section. A pooled cross section is analyzed much like a cross section. It increases sample size and helps to see how a key relationship has changed over time. An effective way of analyzing the effects of a government policy.
Dr. L Vn Chn FTU, 2011

08/11/2011

1.3 Structure of Economic Data

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Panel or Longitudinal Data A panel data set consists of a time series for each cross-sectional member in the data set. Key feature: the same cross-sectional units are followed over a given time period. Data in HPRICE3 are not a panel data set because the houses sold in 1978 and 1981 are likely to be different, only small duplicates. E.g., CRIME3 contains a 2-year panel data set on crime and related statistics for 53 districts. Each district is numbered from 1 to 53. The ordering is irrelevant. 2-years of data for district 1 fill the first 2 rows or observations. Observations 3 and 4 corresponding to district 2.
Dr. L Vn Chn FTU, 2011

1.3 Structure of Economic Data

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2 years of data for each district are placed adjacent to one another, with the first year coming before the second. Advantages over cross-sectional data or even pooled cross section: - Multiple observations on the same units allows to control unobserved characteristics of units. - We can study the importance of lags in behavior or the result of decision making. This course is concerned with analysis of cross-sectional data as it poses the fewest conceptual and technical difficulties. But it illustrates most of the key themes of econometric analysis.
Dr. L Vn Chn FTU, 2011

1.4 Causality and Ceteris Paribus

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An economist wants to infer that 1 variable (such as education) has a causal effect on another variable (such as worker productivity). Causal effects must come from economic theories, otherwise we just know their correlation. In causal analysis, there is the notion of ceteris paribus which means other factors being equal. E.g., in analyzing consumer demand, we are interested in the effect of changing the price of a good on its quantity demanded, while holding all other factors (income, other prices, tastes) fixed. In practice, it is not possible to hold all else equal, except in very special cases.
Dr. L Vn Chn FTU, 2011